Compass Diversified: Could Be Better For Shareholders (NYSE:CODI)

For most of the time I’ve followed Compass Diversified Holdings (NYSE:CODI), my feelings have been some version of “it’s alright… I guess”. Indeed, since my first piece on the company for Seeking Alpha, a positive write-up, the shares have basically matched the S&P 500 on a total return basis. Likewise, since my last piece, with a total return just a bit below the S&P 500.

Some of my lack of enthusiasm can be traced to what I’ve felt was a lack of capital recycling activity – a management team too willing to be passive and hold its portfolio instead of making more opportunistic transactions. That seems to be changing, with management selling several businesses in recent years and putting out a multi-year growth target that will require more acquisitions and faster revenue growth from its portfolio.

This strategy does carry some risk, but Compass brings a lot of positives, including a low cost of capital, an attractive operating structure for potential founder-sellers, and far more patience and long-term focus than most private equity buyers. I do consider a competitive M&A environment to be a risk, and the valuation today isn’t spectacular, but I think this is a “steady as she goes” investment idea with some opportunities for outperformance-driven upside.

Supply Chain Issues Are Pinching, But Markets Are Recovering

Looking at the current portfolio, there are definitely some signs of stress in the business from supply chain issues. Businesses like 5.11 and Velocity both achieved less than they could have in the fourth quarter in terms of revenue and profits due to supply chain issues, and I don’t expect those pressures to ease up soon, time does give management some opportunities to find workarounds.

Meanwhile, the overall demand backdrop is still healthy. With pandemic restrictions going away, people are shopping again, and the consumer business posted 23% year-over-year revenue growth in the fourth quarter. The industrial businesses are also doing better; Sterno remains a laggard, but Altor is benefiting from packaging demand while Arnold is leveraged to improving end-markets across the aerospace, auto, and industrial landscape.

Beyond Arnold, I wouldn’t really characterize any of the portfolios as particularly cycle-sensitive or cycle-driven. Lugano, a luxury jeweler catering to high-net-worth individuals should do better in good times, but the HNW market tends to be less sensitive to downturns. This lack of cyclical leverage is arguably a positive at this point, as many industrials with short-cycle exposure have weakened with the Street already moving on from those names.

Speaking specifically of Arnold, this is a business that still intrigues me over the longer term. As the largest U.S. manufacturer of engineered magnets and one of two domestic producers of rare earth magnets, I believe this company should have good exposure/leverage to trends like industrial automation and electrification, the “inverterization” of appliances, and vehicle electrification. Why this isn’t featured more prominently by management makes me wonder what I’m missing here.

Time To Play Offense

Management has been a lot more active lately on portfolio recycling, selling Manitoba Harvest and Clean Earth in 2019, Liberty in 2020, and currently in the process of selling Advanced Circuits to a SPAC for a sizable gain. They have also been busy on the acquisition side, adding Marucci and BOA in 2020 and Lugano in 2021, as well as multiple tuck-in deals for portfolio companies.

Management has also signaled their intentions to monetize the 5.11 holding through an IPO, though that plan has been shelved for the time being given market conditions.

Judging by management’s commentary at the late 2021 Investor Day, it sounds as though they’re gearing up to be much more active, and I think that will be to the long-term benefit of shareholders. For years, management has touted numerous intrinsic advantages to their approach, including a low cost of capital, long-term holding periods, and a willingness to reinvest in acquired businesses – the latter two, in particular, making Compass a more attractive prospect for sellers – but the company hasn’t been as active as I’d like with its portfolio.

With nine holdings in the portfolio today and a longer-term target of 15, clearly, there will some acquisitions in the years to come. While management says it will do deals for up to $600M, $200M to $400M has been the sweet spot for the last decade or so, and with around $1.1B in deployable capital today, I don’t think the company will struggle to reach that target – provided, of course, that the market cooperates. Knowing this management team, they will miss that 15-holding target and hold surplus capital rather than overpay for an asset.

It’s not just about adding more companies to the mix, though. Management also seems to be signaling an increased willingness to invest for growth and to invest in faster-growing companies. Compass has continued to invest in portfolio companies like 5.11 and Marucci to drive better long-term returns, and the company is looking for portfolio revenue growth to accelerate toward the high-single-digits over the next five or so years.

In pursuit of better growth opportunities, Compass is also broadening its horizons with respect to the companies it will acquire and looking to add assets in healthcare. I do see execution risk here from entering into new markets with substantially different dynamics and drivers than the company’s historical areas of consumer and industrial goods, but I think management is up to the task and will add personnel as needed to drive this effort.

A Simpler Company

Another significant change since my last write-up on Compass is the company’s conversion to a C-corp structure. This eliminates the complications of the former partnership structure, including the dreaded annual Schedule K-1 forms. While I don’t know that this change will meaningfully alter the competitiveness or attractiveness of the business on a core basis (it’s not as though they routinely offer shares in acquisitions), it will make life simpler for investors, and it opens the shares to a wider range of institutional investors, as many investment mandates exclude partnerships.

The Outlook

I like the progress that I’ve seen over the years at businesses like 5.11 and the opportunities at companies like Marucci and Arnold. Given my concerns and complaints over the years about a lack of portfolio turnover, it’s no surprise that I’m in favor of this more active approach from management to identify and maximize value, as well as this willingness to make growth-generating investments and/or target faster-growing companies in its acquisition strategy.

What I don’t like is the current deal environment. It’s the exception to find an industrial company that doesn’t want to do strategic M&A right now, and while the SPAC frenzy has died down, I don’t think interest in M&A has waned all that much. That creates competition for Compass and will likely lead to some businesses it would like to own going to other investors willing to overpay.

With an increased interest in investing for growth and finding more portfolio holdings, I’ve increased my revenue estimates, driving a higher long-term revenue growth rate (around 5.5%). I realize there are issues with modeling in M&A, but by the same token, I think you end up underestimating the value of a business like Compass if you don’t try. In other words, this is about trading precision for accuracy – I’ll be surprised if my revenue estimates out beyond a year or so are all that precise, but I think including some assumption of future acquisitions brings my three-year, five-year, and 10-year estimates closer to the mark.

That revenue growth should, in turn, drive distributable cash flow growth in the high-single-digits, almost double-digits, over the next decade. Management will likely retain some of that to fund the acquisition and investment initiatives, but it does lay the groundwork for better distributions to investors in the future.

The Bottom Line

Between discounted distributable cash flow and an EBITDA-based sum-of-the-parts approach, I believe that Compass is undervalued below $27.50 today. I don’t expect this to be a blockbuster return prospect, but I do think the company has a formula/strategy that works and that patient investors will get respectable returns – possibly more than “respectable” if this pivot towards more activity and focus on growth works out better than I expect.